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Lessons of a subsidized, bankrupt iron plant

Ed Lotterman: Real World Economics
Ed Lotterman: Real World Economics

A bankruptcy court battle between a state and a steel company over a stalled iron-ore mining and processing plant offers several economic lessons. The case of India-based Essar Steel Minnesota also shows why bankruptcy is a necessary evil for an efficient economy.

Let’s start with some history. Minnesota produced millions of tons of “direct-shipping” iron ores for decades. These ores required little processing but were finite. Research showed how lower-grade ore might be used. The state amended its constitution in 1964 to encourage new plants, and many were built.

However, new high-grade ore was found in Brazil, Australia and elsewhere. Global steel production grew, especially in China.

Many U.S. mines closed. But as the industry experienced a shake-out, research continued. Technology developed for “direct reduction” of ore, allowing the processing of ore into iron right at the mines instead of at distant steel plants. Reduction heats iron ore to burn off its carbon and oxygen, leaving pellets of 90 percent or more pure iron. Plans emerged for building a direct-reduction plant in northeast Minnesota.

In the new century, economic growth in China put the world into a commodity price boom. Ore prices increased 10 times over. Projects not financially viable at low prices suddenly were.

Enter Essar. The Minnesota project was already planned when the company bought its way into it in 2008.

As is usual, it sought government subsidies. Minnesota gave a $64 million grant. Construction-equipment buying began.

Unfortunately, this coincided with the global slump. The new plant ran onto financial shoals immediately. There were frantic negotiations with investors, construction stoppages and late payments to contractors and vendors. Now the company has filed for Chapter 11.

There are at least three separate sets of interests.

One is taxpayer money.

Secondly, contractors and vendors are being stiffed. Most will get little recourse in bankruptcy court.

Thirdly, the region anticipated growth in employment and economic activity. It seemed new technology might revitalize the entire iron sector. That hope is nearly gone.

Now, losses have to be shared. Yet there is much value in a nearly completed plant. The fight is over who bears losses and who gets that value.

The economic lessons?

One is the idea of sunk costs — investments that are not recoverable. A new mining truck on site can be dismantled or sold and is not a sunk cost. Concrete and rebar in the enormous foundations needed for machinery of this scale are not recoverable and thus are sunk. Sunk costs are financial spilled milk. One has to ignore them going forward.

Another is that sales by small businesses to a large project are “lumpy.” A farmer can apply 100 pounds of fertilizer per acre or 105 or 117. But she cannot go from having one tractor to 1.05 or 1.17 tractors. Tractors are “lumpy” — you either have one or two or three, but not some fraction of a tractor. Similarly, a concrete business bidding on work at a new ore plant is in an all-or-nothing situation. It can take on a very large and potentially profitable deal that also exposes it to large losses in case of default. Or it can opt out completely. But it usually cannot calibrate its share of the business to a level that will not cause financial harm if the project runs onto the rocks.

A third, more complex lesson is in the strengths and weaknesses of bankruptcy.

Aggrieved creditors see unfairness when courts rule they cannot recover loans or get paid for work. Yet decrees discharging debt recognize the practical reality that the money simply isn’t there. If all the debt of a failed enterprise cannot be paid, it is better to have rules on who gets how much rather than a free-for-all.

Moreover, if laws make business failure too onerous, then people will be more cautious about making investments. This means slower growth of output. Fewer needs and wants of people are met. Society is worse off.

Bankruptcy law cannot make it too easy to write off debt, because entrepreneurs would take on too much risk. When that happens, resources disappear down rat holes, creating an economic disincentive. Lenders and vendors must spend more time and money researching the viability of customers. Interest rates will be higher for all borrowers, because more resources will go into such due diligence and into debt write-offs.

Writing bankruptcy laws that strike an economically efficient medium is hard. No matter how one does it, injustices occur. And bankruptcy gets even more complicated when government itself is either a debtor, as is the case with Puerto Rico, or a creditor, as is Minnesota for this India-based steel company.

The basic premise of Chapter 11 is that often it is better for society as a whole and for most creditors if an enterprise keeps operating than if it is liquidated. That is true in this case. Construction is far along. Society would be better off if the project were completed than if what is in place were left to rust.

But the next steps will be in federal court.

St. Paul economist and writer Edward Lotterman can be reached at